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Financial Stability Report for November 2010

New Zealand’s economy and financial system have benefited from the recovery in the global economy over the past year.

New Zealand’s economy and financial system have benefited from the recovery in the global economy over the past year. The extreme conditions in financial markets during the crisis have abated and stronger activity in New Zealand’s key trading partners has supported a modest rebound in economic activity. New Zealand’s banks have strengthened their funding base over this period, leaving them better placed to meet future credit demand and support economic growth. Bank asset quality also remains strong despite an increase in non-performing loans following the recession.

However, New Zealand’s economic recovery has been tepid to date, with more recent indicators suggesting the pace of recovery has slowed. Households and businesses have restrained spending in an effort to reduce debt levels, lowering the current account deficit. Strong export commodity prices have also helped to reduce the current account deficit, but a sustained rebalancing of economic activity toward the tradables sector will be difficult to achieve with the New Zealand dollar remaining at relatively high levels.

Despite strong commodity prices, prospects for exported growth in New Zealand and adjustment of the country’s external position may also be hampered by a fairly soft global growth outlook. With economic growth recently losing momentum in some advanced economies, interest rates have fallen and additional quantitative easing measures have been announced in the US aimed at bolstering the recovery.

Some countries are facing exchange rates that are not helping in the reduction of their external imbalances. Many developed economies are continuing to adjust to excess leverage on household, business and financial sector balance sheets built up prior to the financial crisis. Growth in these countries is likely to remain sluggish for a significant period of time while efforts are made to restore balance sheets to healthier settings.

Financial markets have continued to question the sustainability of the fiscal positions of some economies, particularly within Europe. In response, many developed countries are now removing fiscal stimulus at a time of continued economic weakness to return fiscal positions to more sustainable levels. The withdrawal of fiscal stimulus is further dampening the pace of recovery in these economies.

In contrast, Australia and emerging Asia have continued to grow strongly despite the weak recovery of the major developed economies. Concerns in some of these economies have turned to trying to tame overheated domestic asset prices. In particular, Chinese property prices have shown spectacular growth over the past year, largely driven by growth in domestic lending. A slowdown in China could materially affect New Zealand, particularly if New Zealand’s export prices fall. Over the medium term, emerging Asia faces challenges sustaining an export-led growth strategy. In this regard, policymakers in the region are likely to face external pressure for greater exchange rate adjustment and increased efforts to boost domestic demand.

The New Zealand banking system withstood the financial crisis well but the heavy reliance on short-term wholesale funding from international markets was exposed as a key vulnerability, both for the banking system and the economy more generally. Since the crisis, however, and consistent with the prudential liquidity policy introduced in April this year, banks have substantially increased the proportion of retail and long-term wholesale funding on their balance sheets. Locally incorporated banks now comfortably meet regulatory requirements for core funding. International term funding markets have generally remained accessible to New Zealand banks. However, conditions have been difficult at times, particularly earlier in the year when concerns over the sovereign debt positions of peripheral European economies led to a broader disruption of debt markets. Notwithstanding these sovereign debt concerns, funding market conditions have generally improved, allowing the Reserve Bank to discontinue the offering of term funds through its regular Tuesday open market operation, the last remaining emergency liquidity facility introduced during the financial crisis.

After increasing steadily from the middle of 2007, nonperforming loans in the banking system now appear to be approaching a plateau. Bank profitability is also improving. However, a further weakening in the recovery has the potential to generate further loan losses in the banking system. House sales have stalled for the past six months, and there are signs of prices falling again. Were this to be accompanied by renewed weakness in the labour market, some mortgage borrowers would find themselves in a position of financial stress. Furthermore, the banking sector remains heavily exposed to developments in the agricultural sector. Strong increases in commodity prices over the past year have boosted the cash flow position of many farms. Nevertheless, agricultural land values have been falling and farm sales volumes are very low. Any material drop in commodity prices could expose relatively indebted farms in the sector to significant stress.

In contrast to the general resilience of the banking sector, sections of the non-bank deposit-taking (NBDT) sector have experienced continued difficulties over the past six months. Three finance companies have failed since our May Report, the most notable being South Canterbury Finance, which went into receivership on 31 August owing $1.6 billion to depositors. These finance companies were covered by the retail deposit guarantee scheme, which has limited the wider fallout of the failures. The original term of the scheme expired on 12 October. Seven NBDTs have registered for the more stringent extension to the scheme, which will run until the end of next year.

The NBDTs that failed over the past two years were generally those with heavy exposure to the property development sector, a sector that saw high rates of losses in the economic downturn. The firms that remain in the industry have reduced their exposures to property development, thus providing a foundation for recovery and industry consolidation.

Another driver of industry consolidation will be the new regulatory requirements for NBDTs, most of which will be in place by year-end, although the full licensing framework is still under development. A further regulatory development has been the passing into law of the Insurance (Prudential Supervision) Act. This gives the Reserve Bank responsibility for prudentially regulating and supervising licensed insurers. Meanwhile, further progress has been made in international forums to improve the broader regulation of the international financial system. The Basel Committee on Banking Supervision has announced a range of measures to strengthen existing bank capital and liquidity requirements. The new framework, known as ‘Basel III’, is likely to be adopted by the G20 leaders at their upcoming meeting in South Korea. The Reserve Bank generally supports the new prudential standards but intends to assess fully their potential impact on the financial system before initiating any changes to the New Zealand supervisory framework. The financial stability ‘cobweb’ provides a visual summary of the outlook for the New Zealand financial system, and reflects broadly unchanged financial stability risks since the May Report (figure 1.1 in attached PDF).

While financial markets have recovered somewhat from the sovereign debt crisis in April-May, the global economy has struggled to recover from the recession. Chapter 2 discusses the risks that deleveraging and constrained fiscal conditions pose to the global economy.

A slowing in the momentum of the domestic recovery, along with weakness in the housing market, is reflected in an outward shift in the ‘domestic environment’ dimension of the cobweb. This deterioration in the outlook has been tempered to some extent by moves on the part of households and businesses to reduce debt levels, reducing New Zealand’s current account deficit (chapter 3).

Chapter 4 discusses the capacity of the capital and funding buffers of New Zealand’s banking system to absorb the risks identified in the top three dimensions of the cobweb. Non-performing loans and profitability have stabilised over recent months, as reflected by an unchanged rating for ‘capital and profitability’. There have been ongoing improvements in the funding position of the New Zealand banking system, as indicated by material improvements in the core funding ratio. Nevertheless, funding markets remain somewhat fragile, as indicated by the ‘funding and liquidity’ dimension still sitting slightly above normal.

Alan Bollard

Financial Stability Report conference video for November 2010